Tuesday, June 01, 2004

Political Economy: Market Pricing for Alqueda Risk

Ian Walsh of BOP-news has a scenario up trying to weigh the odds of Alqueda contesting the United States for supremacy in a dynamically unstable or non-linear model.

The Economic Background or the Game Board

Ian writes that:

The US needs a lot of money. Every soldier is a walking money drain. The entire logistical train of the US military is mind bogglingly expensive. And it all rests on a worldwide web of commerce and finance that is easily subject to shocks. Billmon has pointed out that al-Q'aeda could easily cripple Saudi production, sending prices at the pump to six dollars a gallon. The only reason they haven't is that they want to capture it themselves. Bin Laden has always seen the oil as a gift from Allah to his chosen and he wants it under his thumb.

But even without doing that the price of oil is eight dollars a barrel higher than it should be based on simple supply and demand. That's a risk premium. It's not hard to imagine attacks from al-Q'aeda that could send that risk premium even higher. Remember the "oil shock"? Want to experience it again? Well, it's one play that al-Q'aeda has that would be fairly easy to do.

And when you add in the fact that a huge new recession is coming down the pike even without such problems... Well let's just say that things look a little dicey for the US on this front.

The recession coming is not so much huge as the problem of debt service. With an economic downturn and tightening monetary policy, the drying up of liquidity as interest rates rise at the same time as the economy goes through a real-estate retrenchment phase is going to cause a sharp rise in defaults. We know consumer debt is at an all-time high and that asset-stripping like home-equity loans (the poor man's second mortgage) have drained top-lines among consumers precipitiously.

The asset-liquidation phase of the coming recession is likely therefore to be more harsh than previous ones. This is only to be compounded by the tightening of anti-bankruptcy laws a few years back by the GOP Congress. The end result is likely to be a much more sharp contraction of aggregate demand than projected by the Federal Reserve in its "behind the curve" deliberately gradual rise of interest rates.

Combined with both commodity inflation and monetary-supply inflation from a retrenchment of foreign reserve holdings into a diversified portfolio that will weaken the US dollar in favor of the yen, euro, gold, and oil the losses of the marketplace participants who haven't been able to hedge their positions (everyone except the big institutions) will be considerable in real terms. The deflection of the CPI from actual conditions may continue to impose an illusion of wage-stability but in PPP terms the American dollar will definitely buy much less than before and a problem that will be compounded as the current accounts deficit grows.

It is "conventional wisdom" that the best way to drive down the current accounts deficit is to drive the country into a recession. However the current accounts deficit only grew in absolute terms over the last recession. This indicates that the conversion of equity assets in this country into capital flight has reached a level in which a structural hemmorage of production capacity has been attained. The only "bright" spot in this scenario is that skilled services should see an uptick, but that this will come at the cost of benefits and income being squeezed by third world competition from increasingly well educated Far Asian competitors that have lower structural labor costs such as education, etc.

THE CONCEPT OF A RISK PREMIUM

Even if Bin Ladin does go, his lieutenants are if anything even more radical. Al Zawahiri is more zealous than Bin Ladin who's medical condition and health have seemed to have made more laid back if such a thing could be contemplated. The real however cost in the interim will not be the eventual defeat or victory. The ongoing economic impact of such a struggle will be measured through a concept known as a risk premium.

The risk premium is not meant to be the actual cost of something going wrong. Paying your insurance premium for coverage is not a risk premium. A risk premium is a price you pay to undergo an increased risk. It is a function of both an estimate magnitude of the disaster and its perceived likelihood. It is the additional surcharge placed in order to continue conducting business with an entity that has potential liabilities above and beyond the transaction itself. Since it is a function of an estimate of liability coupled with an estimate of probability risk premiums are notoriously off-kilter from actual costs and risks.

A market for instance may charge a ridiculously low risk-premium such as the current risk-premium on oil. Why? Because people are beholden to buy oil to fuel their economies. This means that they are a captive crowd of buyers. The risk premium therefore will be understated. The buyers don't actually have a choice to go elsewhere seeing as there are no large-scale economically viable alternative energy choices without attendant infrastructure investment costs (the cost say of converting the whole country to use more solar). Hence the cost for continuing to do business is going to be much lower than the actual amount that would be needed to persuade a free actor - one who had a viable choice of abstenation - to continue engaging in transactions.

What does this tell us? If the current risk-premium in the oil market is about $6-$10 a barell then the actual risk-premium for a "free agent" would be much higher. How much higher? Easily two or three times higher. This would be for instance the cost of convincing someone to continue using oil when they could switch to coal. (How do I estimate this? Only crudely but using the numbers from the last oil shock and seeing the price point divergence at which research in alternative energy was sparked and at which descending price mark such research tailed off is a good zeroeth order estimation) Note that even at $20-$30 pb risk premium is not the cost of the actual damage which is what an insurance premium would attempt to cover. If the cost of oil were to receive a supply shock equal to the 1970's in terms of inflation-measured dollars the price of oil would have to be about $80 pb. Even on the upper end of a "free agent" risk premium of $60 pb is $20 pb too short by that measure.

It is easy to convert these numbers because as long as we stay on oil we presume an open-ended commitment which makes it easier to discern than insurance which has "whole-life" or other such less than absolute disctinctions in policy coverage.

TINSTAAFL

So should be be grateful that the market does not insist because of the beholden or invested natured of the oil-market participants? No, because typically when a market cannot efficiently price a service (such as risk premium) then other factors must come into play. Indeed if the market were able to efficiently price all goods and services with perfect information for all potential factors being foreseeable and complete free agent choice implied, then the EHM hypothesis would hold. However since there are factors that are not taken into account, something else must give besides the market pricing.

This is likely to be a curtailment of foreign investment into the unstable regions and a capital flight from the regions. Imagine if you are a well-off family in the region of Saudi Arabia or Pakistan. How would you hedge against the possibility of a political regime reversal. Well you might spend more money to send your children to live and school overseas. You might invest in "non-productive" assets such as escape routes, vehicles, supplies. You might curtail certain activities such as investment in productive assets and ventures in your own country. You would send your money to safe-havens overseas and internationally in order to save for a "rainy day".

The failure of a proper market premium for oil may be essentially an asset-stripping and capital flight scenario from the region along with lowered productivity from increasingly hesitant joint foreign ventures. If you had a choice between doing business with a bank in Saudi Arabia and an equally profitable venture in London, which would you choose in this political climate? Capital is a coward and its operations and assets are fairly easily disruptable or seizable given anything less than a rule-of-law regime with clear and enforced property law and visitor-national-employement security safeguards.

This was the real target of the Alqueda wing attacks on the Khobar foreign national hostage situation in the last few days. While I rejoice at the rescue of most of the hostages alive, the main impact will be economical. It is hardly likely to be a liquidation of present assets there by foreign ventures, but it is likely to inhibit expansion or new investment. The domestic capital flight from citizen's hedging will be far worse.

The Economic Impact on the States

At first we will benefit, if nothing else because of the capital flight here to the States or the ventures overseas that might have drawn investment away from the present country. However political displeasure has a way of making itself felt in economic terms in manners far removed from simplistic boycotts. By making itself a stench in the nostrils of the nations of the earth, the United States can be expected to forfeit any good will in remaining negotiations diplomatic and economic with other nations.

This will result in us having to bribe people where once we could cajole them. Those that we had to bribe in the past will then charge a "rogue state" surcharge to their graft and corruption on top of past costs of business, making it more expensive to bribe those we must bribe. The sense of cooperation and relaxed detente that once greased the wheels of business will evaporate. This will perceptibly if subtly make itself felt in the negotiations of trade relations and treaties and the resolution of disputes in the form of harder driven bargains and harsher reactions to trade disputes.

Tragically the benefits of engagement on the economic level will be undermined. It used to be that if the United States engaged with market-based trade and development aid it brought a certain political deportment and improvement of relations even with ideological foes. We will feel frustrated in the future ever increasingly as other countries trade us in order to obtain our "filthy lucre" but fail to become friendlier to us or perhaps openly use their profits to fund activities offensive to us. Politicians will be less able to give us open cover against their populaces by joining us in political accords, and there will be some who capitalize on our unpopularity by joining the demonization of American values and policies for crass political gain. This has already begun.

The overall distributed effect of all these minor but appreciable shifts in the world business and political environment will collectively and without being able to point to any one single factor become a drag on our growth. For many years America has enjoyed an (invisible precisely because it was collective, implicit, and distributed) prosperity enhancement boost from the good will of the nations of the world. Now we will find that not only removed but a slight burden to our continued economic progress substituted just as invisibly but just as tangibly by the increased anti-American sentiment.

In a death of a thousand tiny cuts: our foreign-exchange students will be treated more coolly or actually in hostile terms overseas, our businessmen will have to struggle just a bit more harder to compete with companies from Europe, our opportunities in Asia and the Middle-east and the developing world in general will have the playing field tilted ever so detectably against us, our paperwork will require just a bit more effort to finish unwinding the red tape, and foreign officials will be just a smidgen more reluctant to make exceptions for our nationals when questions of ambiguity regarding bureaucracy and legal issues.

RACISM, PREJUDICE, and MARKET TRANSFERENCE

You might ask how much the collective weight of such ire could depress our prosperity in noticeable terms. That this question must be asked is a measure of America's blindness to the power of entrenched cultural patterns of dysfunction joined in a feedback loop with the power of pervasive and implicit social prejudice. No one ever stops a little black kid and tells him that he can't grow up to be a scientist, or just stay off of welfare and out of jail. Nonetheless the "invisible hand" of continued social bias, just a few tiny fractions of a degree cooler in any given instance than the reception and treatment of a person of a different background prove cumulative, crushingly real, and statistically significant in socio-economic outcome over the long run.

This isn't because of any one factor. It isn't because Americans tell themselves that black people are more likely to shoot other people. It isn't because Americans tell themselves in any direct or meaningful fashion that black people are more likely to do drugs. It is isn't because most Americans would ever admit thinking even in their deepest hearts of hearts that black people are more likely to smoke, become teenage moms, or welfare queens, or whatever naked form of prejudicial stereotype one could imagine. However the cumulative and aggregate total impact of tiny variations in reception and interpretation - a second's hesitation here and a moment's digression there - is in sum and total enough to jaundice the social interactions over large groups of people and over time.

One of my readers asked me to assess the impact of continuing to destabilize the Mid-east for America will be economically. I would imagine that over time it could prove potentially a permament 2%-3% drag on GDP growth. How is this number arrived at? That is simple. It assumes that for every ten dollars ($10 pb) on every barell US light crude in the actual risk premium the market should charge there will be a correlated 1% drop in GDP. The actual economic drag would come partially in terms of higher oil costs, partly in lower returns for international efforts, and partly in higher costs of business imposed in a sort of odium surcharage or outrage tax cumulatively and collectively from the distributed penalties imposed by people exacting in a million infinitesimal tariffs of market risk premium compensation. The basis of this argument is quite simply the theory of value and an extension of the Efficient Market Hypothesis (TINSTAAFL extension).

If the risk premium is not efficiently priced by a rational market then people impose penalties in other fashions until it accrues a compensating loss otherwise. This is not a logical sort of affair. This is not because they were attempting to recoup their own losses in a rational fashion from the increased cost of oil. It is simply a concept of psychological justice that however outrageous or crude is commonly seen in practice. Suppose you knew someone who shot up the liquor store down the street but the police didn't haul them in. Even if you had to deal with them, you would shy away from them and be less forgiving. It seems illogical that the total stress of the risk premium would be transferred this way but this is the way that people act which is to say irrational.

To see why we would argue that clearly the political percussions of the present arrangement would be clearly different if the price of oil were at $60 a barell. Then both the political costs and the economic costs are the same. However since oil is priced by human beings, and we are only giving them $40 pb worth of rational reasons (the market) then the other $20 or so pb is going to be transferred to us by other means because we are putting $60 pb worth of stress on emotional and irrationally motivated human beings. In a situation where you are causing $60 pb worth of trouble but only $40 pb can come out into the open, then the other $20 is going to find a way to sneak around back and bite you in the arse just because that's the way people are.

You could argue that wouldn't this ire be spread around the world? But if we are responsible and "shit rolls downhill" then it would all sooner or later get back to us. This is a completely irrational statement, but anyone familiar with family dynamics should be perfectly familiar how the "bad child" has animus from the entire unit redirected back at them whatever the formal arrangements otherwise.

This is the essential dilemma of racism's liberal opponents. They could abolish the laws criminalizing miscegany, supporting Jim Crow, creating formalized segregation, etc. Liberal proponents of racial equality however have been stymied as subtle shifts in sentiment and group phenomena such as social gentrification found a way to socio-economically transfer into implicit resistance what became established barriers to African-American progress. When the liberal agenda overplayed its hand, mostly implicit and distributed widely diffused factors of prejudice restored the statistical equilibrium of the African-American socio-economic status to what the collective consensus (again implicit) felt it should generally be. The fact that the formal and legal barriers to equality had been removed and judicial intervention mandated inclusion could not counteract this process. The same sort of transference to implicit mechanisms is the best way to understand the transfer of the uncharged risk premium into an odium tax on America so long as it "misbehaives".

This would seem to fall in the 2% to 3% range in national GDP loss using a back of the envelope calculation. However 3% GDP growth is the difference between a boom and a recovery, between a recovery and a stagant economy, and between a static economy and a clear recession, and a recession and a depression. That is the likely cost of continuing to be the "bad" or "dangerous" crazy in the community of nations.

To put it more bluntly in the kinds of terms used by Chris Rock, black comedian, we have just become the Nigger of the International Economic Community.

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